Colin Magee pitches a different way to list and trade shares for SMEs, allowing them to access capital markets efficiently and transparently, but on a 'periodic' basis

New Zealand’s capital markets have a perennial problem growing mid-sized SMEs into our next batch of investable businesses.

Our small population and geographic isolation are contributory factors limiting the growth of local businesses, but that’s only one part of the story.

Businesses need efficient access to capital to grow, and that means having an efficient way to connect with investors. Even more so in times of increased economic pessimism, as we’ve seen for most of 2022.

For smaller businesses, periodic auction trading has been proposed as a solution to improve the efficiency of connecting businesses with investors, with NZ’s updated securities legislation passed in 2013 explicitly endorsing periodic markets for smaller businesses.

Recently, in what appears to be a world first and definitely a first for New Zealand, we have seen the settlement of the first ever secondary market periodic auction, open to retail investors as well as sophisticated investors, through Catalist’s licensed public stock exchange.

But how does periodic auction trading work in practice and is it really the answer for bringing liquidity to smaller businesses?

Continuous trading vs periodic auctions

Efficiency in capital markets isn’t as simple as just creating the lowest-cost marketplace possible. Yes, businesses want low-cost access to capital, but for investors the cost of making a bad investment decision usually outweighs the desire for a bare-bones investment mechanism.

Investors need to be confident in the quality of disclosure information, and the fairness of pricing, before they hand over their investment capital. That’s why, no matter what the political situation in a country, stock exchanges are invariably subject to significant regulation, as investor protections will tend to encourage more efficient flow of investment capital.

We’re all familiar with how this works for New Zealand’s largest businesses. For businesses listed on the NZX, continuous disclosure requirements and continuous trading give investors transparency of information and fair pricing. This encourages investors to support the businesses they think are most likely to successfully grow their business.

For smaller businesses, traditional stock markets have never worked well. The low volume of trading means investors can’t be confident the last traded price is still fair, which discourages further orders, leading to a downward spiral of liquidity.

Professional market participants are likely to be familiar with the concept of ‘call auctions’, which are designed to short-circuit this downward spiral of liquidity. Like most major stock exchanges, NZX starts each day with a short call auction, during which time, no orders trade. Instead, orders are batched up, with everything trading at a single price, just prior to the market opening for continuous trading. This removes the disincentive for investors to place their orders into the market when it first opens, improving the volume of trading and ensuring ‘orderly’ price setting.

The Catalist Public Market, licenced as New Zealand’s junior stock exchange by the Government last year, takes this approach for all secondary market trading. Trading is batched up into periodic call auctions, to improve liquidity and ensure fair and orderly pricing.

A case study: Matū Iramoe Limited

Although not the first secondary market auction accessible to sophisticated wholesale investors, Matū Iramoe’s auction was the first ever secondary market auction of its type, open to retail investors as well.

Matū Iramoe is a venture capital fund, investing in a portfolio of (currently 16) deep tech and science businesses. These are businesses doing things like creating new delivery mechanisms for cell therapies, building non-invasive technology to investigate gastric disorders and building touch-detection materials for soft robotic structures. Investment into this type of early-stage fund would usually take many years to mature, with capital being locked away until the fund made an exit by selling their underlying investments in IPOs, or sales to a larger businesses.

The listing on Catalist’s Public Market means investors are given regular opportunities to exit, by offering to sell during periodic auctions. In Matū Iramoe’s case, they will hold secondary market trading auctions every 6-months, with additional capital raising events held inbetween.

Unlike trading on the NZX, Matu Iramoe’s secondary auction was open for a week, during which investors could submit bids (to buy) the shares, by indicating the maximum price they would be willing to pay and the maximum number of shares they wanted. Investors who already held shares could offer to sell their existing shares, by indicating the minimum price they would accept for their shares and the maximum number of shares they would sell. This information was displayed in a live order book, in real-time during the auction.

At the end of the main trading period, there was a 24 hour ‘pre-close’ period, where investors could improve their existing orders by up to 10%, but no new orders were accepted.

Being listed on a licensed stock exchange means Matū Iramoe, and any other listed business, is required to release all material information before any investor can trade their shares. Licensed stock exchanges are also required to implement a range of controls, designed to ensure a “fair, orderly, and transparent” market.

One of the more visible controls in Catalist’s case is the use of ‘auto orders’ to help improve price stability. These orders are only submitted into the order book when there’s a corresponding order they could trade with. The auto orders only get submitted at the price needed to trade, but automatically get re-submitted at incrementally better prices, up to the investor’s best price, if they are outbid.

Auctions such as that held by Matū Iramoe, or the short auction at the beginning of every day on the NZX, or other international exchanges, tend to follow the same simple rules around the world. The price set for the shares is the price at which the largest volume of shares would trade – effectively the equilibrium price based on the total supply and demand. In the case of Matū Iramoe, this was $1.09, which was a 9% increase on the price at which the shares were most recently offered for sale earlier this year.

This shows the confidence investors have in this fund, but more importantly it shows the concept of periodic trading is working in practice, to help generate liquidity for a product that would usually be illiquid.

Ken Erskine, a Matū Iramoe Director, says “We were pleased to see an excess of demand over supply in the recent auction. The auction mechanism seemed to work smoothly, and we were able to step in after the auction to issue additional shares at the clearing price to satisfy the excess demand at that price.”

In Catalist’s post-trading survey results, 73% of investors described the process as “Easy – no problems at all”, whilst individual feedback indicates that the trading process is easy to follow when investors get their heads around bids and offers – and particularly how to interpret the current orders.

While the number of investors participating was still small, this was a significant milestone for New Zealand’s capital markets. The total number of businesses, in both the wholesale and retail spaces that are using this mechanism is increasing every month and we expect New Zealand investors will get more comfortable with auction-based trading over the next year or so.

Periodic auctions are already generating advantages for both businesses and investors, so the fact they’re finally breaking into the mainstream is a real win for New Zealand’s capital markets.

Colin Magee is the CEO of Catalist, New Zealand’s licensed stock exchange "designed for growth businesses".